2010 Ans PDF

LEVEL III
Question: 1
Topic: Individual Portfolio Management
Minutes: 35
QUESTION 1 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 35 MINUTES.
Elisa Lima is a 34-year-old widow residing in a country that uses U.S. dollars (USD) as its
currency. She has two children: age 10 and age 6. Lima works as the director of marketing at
Relex Corporation. Exhibit 1 presents details of the financial environment in Lima’s home
country.
Exhibit 1
Selected Data from Lima’s Home Country
• Flat income tax rate of 25%.
• Wages, realized capital gains, and interest are taxed as income.
Taxes • Dividends are not taxed.
• Realized losses may be offset against income and may be
carried forward to offset income in future years.
Health insurance • Government provides at no direct cost to citizens.
• Contributions are pretax and annual maximum is USD 40,000.
• Income and gains grow tax-deferred and portfolio reallocations
Tax-deferred accounts
are not subject to tax.
(TDAs)
• Income taxes are paid on full amount of withdrawals.
• No penalties on withdrawals for housing or education.
Lima’s current pretax annual compensation is USD 140,000 and her current annual living
expenses are USD 96,000. Her future salary increases are expected to match any increases in
living expenses on a pretax basis. Lima is in good health, owns her home, and has no debt.
Lima is a disciplined investor, but a recent equity market decline caused her great anxiety. She
is worried about her ability to fund her children’s education and her retirement. Lima meets
with her financial advisor, Mark DuBord, to review her financial plan.
DuBord notes the following factors:
• Lima invests USD 12,000 (pretax) in a TDA at the end of every year and intends
to continue doing so until she retires. The current value of the TDA is
USD 250,000.
• Lima makes annual contributions to charity of USD 6,000. These contributions
are included in her annual living expenses.
• She will prepay her children’s future education costs at the end of this year.
• Lima participates in Relex’s executive retirement program. At the mandatory
retirement age of 60, she will receive a pretax payment of USD 1,000,000.
2010 Level III Guideline Answers

Morning Session - Page 1 of 67
LEVEL III
Question: #1
Minutes: 35
DuBord determines that the prepaid education costs for both children will require a total of
USD 50,000, including all taxes. He recommends that Lima purchase a life annuity to fund her
retirement. DuBord calculates she will need USD 3,000,000 (pretax) to purchase the annuity at
age 60. Lima agrees with DuBord’s recommendation.

LEVEL III
Question: 1
Minutes: 35
A. Formulate each of the following constraints of Lima’s investment policy statement

(IPS):
i. liquidity
ii. time horizon
(4 minutes)
One year later, after prepaying her children’s education costs and after making her annual TDA
contribution, Lima has USD 225,000 invested in her TDA. Lima’s other financial information
remains the same.
B. i. State the return objective portion of Lima’s IPS.

ii. Calculate Lima’s required average annual pretax nominal rate of return until her
retirement in 25 years. Show your calculations.
(12 minutes)
DuBord also advises Abella Rual, Lima’s sister, a 37-year-old single woman with no children.
Rual works as a bankruptcy lawyer and is president of her own firm. Rual’s annual income is
USD 450,000 and her annual living expenses are USD 180,000. She is in good health, owns
her home, and has no debt.
Rual’s investment portfolio is currently valued at USD 1,500,000. Rual is confident that long-
term equity market returns will more than offset losses in market downturns. She continues to
invest regularly. Rual plans to retire at age 52, sell her business, and donate the proceeds to
charity. Her investment portfolio will fund her retirement expenses.
C. i. Identify two factors that increase Lima’s ability to take risk.

ii. Identify two factors that increase Rual’s ability to take risk.
(8 minutes)
D. Determine whether Lima or Rual has a greater willingness to take risk. Justify your
response with one reason.
(3 minutes)
During a recent review with Rual, DuBord notes that tax law changes, effective next year, will
lower the tax on capital gains to 15% but eliminate the ability to offset income with realized
losses. To minimize Rual’s tax liability, DuBord is considering the optimal location (tax-
LEVEL III
Question: 1
Minutes: 35
deferred or taxable) for her assets prior to the tax law changes. DuBord and Rual agree to
maintain Rual’s current asset allocation. Rual’s investment portfolio and asset location are
shown in Exhibit 2.
Exhibit 2
Rual’s Investment Portfolio
Tax-deferred Account Taxable Account
Asset Class Current Value Current Value Cost Basis
(USD) (USD) (USD)
Bonds 250,000 500,000 550,000
Equities 500,000 250,000 150,000
Total 750,000 750,000 700,000
DuBord recommends the transactions necessary to achieve the most tax efficient asset allocation
of bonds and equities in each account.
E. i. Determine the “sell” amount of bonds and the “sell” amount of equities to
achieve the most tax-efficient allocation in each account (tax-deferred and
taxable).
ii. Determine the “buy” amount of bonds and the “buy” amount of equities to
achieve the most tax-efficient allocation in each account (tax-deferred and
taxable).
iii. Justify, with two reasons, why this is the most tax-efficient allocation.
Note: Assume no transaction costs or liquidity needs.
ANSWER QUESTION 1-E IN THE TEMPLATE PROVIDED ON PAGE 5.
(8 minutes)

LEVEL III
Question: 1
Minutes: 35
Template for Question 1-E

i. Determine the “sell” amount of bonds and the “sell” amount of equities
to achieve the most tax-efficient allocation in each account
Asset class
(tax-deferred and taxable).
Bonds
Equities
ii. Determine the “buy” amount of bonds and the “buy” amount of
equities to achieve the most tax-efficient allocation in each account
Asset class (tax-deferred and taxable).
Bonds
Equities
1.
2.

LEVEL III
Question: 1
Minutes: 35
Reading References:
14. “Managing Individual Investor Portfolios,” Managing Investment Portfolios: A Dynamic
Process, 3rd edition, James W. Bronson, Matthew H. Scanlan, and Jan R. Squires (CFA
Institute, 2007).
15. “Taxes and Private Wealth Management in a Global Context” Steve M. Horan and
Thomas R. Robinson CFA (CFA Institute, 2009).
Purpose:
To test the candidate’s: (1) understanding of the investment policy statement for an individual
investor, (2) ability to assess pertinent factors for an investor’s ability to assume risk, (3) ability
to calculate an investor’s required return, (4) understanding of an investor’s other constraint
factors (5) ability to assess the benefit of Tax Loss harvesting, and (6) ability to distinguish key
differences between human and financial capital.
LOS 2010 –III-3-14-a,h, i, j, k, l “Managing Individual Investor Portfolios”

The candidate should be able to:
a) discuss how source of wealth, measure of wealth, and stage of life affect
individual investors’ risk tolerance;
b) explain the role of situational and psychological profiling in understanding
individual investors;
c) compare and contrast the traditional finance and behavioral finance models of
investor decision making;
d) explain the influence of investor psychology on risk tolerance and investment
choices;
e) explain the use of a personality typing questionnaire for identifying an investor’s
personality type;
f) compare and contrast risk attitudes and decision-making styles across distinct
investor personality types, including cautious, methodical, spontaneous, and
individualistic investors;
g) explain the potential benefits, for both clients and investment advisors, of having a
formal investment policy statement;
h) explain the process involved in creating an investment policy statement;
i) distinguish between required return and desired return and explain the impact
these have on the individual investor’s investment policy;
j) explain how to set risk and return objectives for individual investors and
discuss the impact that ability and willingness to take risk have on tolerance;
k) identify and explain each of the major constraint categories included in an
individual investor’s investment policy statement;
l) formulate and justify an investment policy statement for an individual
investor;

LEVEL III
Question: 1
Minutes: 35
m) determine the strategic asset allocation that is most appropriate for an individual
investor’s specific investment objectives and constraints;
n) compare and contrast traditional deterministic versus Monte Carlo approaches to
retirement planning and explain the advantages of a Monte Carlo approach.
LOS 2010 –III-3-15-e, h “Taxes and Private Wealth Management in a Global Context”
a) compare and contrast basic global taxation regimes as they relate to the taxation of
dividend income, interest income, realized capital gains, and unrealized capital
gains;
b) determine the impact of different types of taxes and tax regimes on future wealth
accumulation;
c) calculate accrual equivalent tax rates and after-tax rates;
d) explain how investment return and investment horizon affect the tax impact
associated with an investment;
e) discuss the tax profiles of different types of investment accounts and explain
their impact on after-tax returns and future accumulations;
f) explain how taxes affect investment risk;
g) discuss the relationship between after-tax returns and different types of investor
trading behavior;
h) explain the benefits of tax loss harvesting and highest-in/first-out (HIFO) tax
lot accounting;
i) demonstrate how taxes and asset location relate to mean-variance optimization;

LEVEL III
Question: 1
Minutes: 35
Guideline Answer:
PART A
i. Liquidity Needs for Elisa Lima:

Lima will fund education expenses for her children in one year at a cost of USD 50,000. Lima
has no other liquidity needs.
ii. Time Horizon Constraint for Elisa Lima:

Lima has a long-term, multi-stage time horizon. The first stage is one year until education costs
are paid. The next stage is Lima’s employment years, 25 years, until her retirement. The last
stage begins at her retirement.
PART B
i. Return Objective Statement

Lima’s return objective is to grow the investable tax-deferred portfolio to purchase a
USD 3,000,000 pretax annuity in 25 years at age 60. Since she will receive a pretax payment of
USD 1,000,000 upon retirement from Relex, the investment portfolio needs to provide USD
2,000,000 of the necessary USD 3,000,000.
Lima’s expenses are USD 96,000. Given the tax rate of 25%, Lima will need 96,000 / (1 - 0.25)
or USD 128,000 of pre-tax income to generate the after-tax income for meeting these expenses.
Therefore Lima’s current pretax annual compensation of USD 140,000 will support a tax-
deferred contribution of 140,000 – 128,000 or USD 12,000. Lima’s income is expected to grow
with her expenses over the remainder of her working life; therefore, the USD 12,000 contribution
to the TDA can be continued annually.

LEVEL III
Question: 1
Minutes: 35
ii. Return Calculation

Investment Portfolio (pretax)
Current portfolio USD225,000
Assets Needed to Purchase Annuity at age 60 (pretax)

Required portfolio value 3,000,000
Lump-sum benefit at age 60 1,000,000
Required value of TDA 2,000,000
Required Return Calculation

Present Value (PV) (225,000)
Future Value (FV) 2,000,000
Annual Savings (PMT) (12,000)
Number of Years (N) 25
CPT I/Y – TVM registry of calculator 7.05% pretax nominal
PART C
i. Factors that increase Lima’s ability to take risk:

Lima has a long time horizon until retirement (25 years) -- a long investment time horizon.
Lima receives a USD 1,000,000 payment at age 60 (retirement).
Lima has the flexibility to stop the annual payments to charity of USD 6,000.
Lima has no debt.
ii. Factors that increase Rual’s ability to take risk:

Rual’s current income significantly exceeds her current level of spending.
She only needs to provide for herself.
Rual’s current portfolio value (USD 1,500,000) is large relative to her living expenses.
Rual does not have to make the charitable contribution upon the sale of her business.
Rual has a flexible retirement date -- a long (15 years) investment horizon.
Rual has no debt.
PART D
Rual has a greater willingness to take risk because:

Rual owns her business.
Rual plans to retire relatively early at age 52.
Rual is confident that equities will deliver positive returns.

LEVEL III
Question: 1
Minutes: 35
PART E
The appropriate division of funds that would maximize Rual’s advantage from the new tax law
change is accomplished by holding all of the bonds in the TDA, and all of the equities in the
taxable account.
The resulting investment portfolio of both taxable and tax-deferred accounts is as follows:
Abella Rual’s New Asset Location

Tax-deferred Account
Asset Class (TDA) Taxable Account
Bonds 750,000 0
Equities 0 750,000
Total 750,000 750,000

LEVEL III
Question: 1
Minutes: 35
Template for Question 1-E

i. Determine the “sell” amount of bonds and the “sell” amount of equities
to achieve the most tax-efficient allocation in each account
Asset class
(tax-deferred and taxable).
Bonds 0 USD 500,000
Equities USD 500,000 0
ii. Determine the “buy” amount of bonds and the “buy” amount of
equities to achieve the most tax-efficient allocation in each account
Asset class (tax-deferred and taxable).
Bonds USD 500,000 0
Equities 0 USD 500,000
Selling the bonds in the taxable account results in realizing taxable losses equal to USD 50,000 at
the current tax rate of 25%, which can then be used to offset income. After the tax law change, the
loss cannot be used to offset or reduce taxable income.
Under the new tax laws, interest income will continue to be taxed at 25%, realized capital gains
will be taxed at 15% and dividends will not be taxed. These trades place the higher taxed income-
oriented assets in the tax-deferred account and the lower taxed capital gain and dividend paying
assets in the taxable account. In addition, choosing to defer sales of equities that appreciated in
value is justified because gains will be taxed at a lower rate in the future.

LEVEL III
Question: 2
Topic: PM – Institutional/Behavioral - Insurance
Minutes: 25
QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 25 MINUTES.
Island Life Assurance is a specialty life insurance company that markets its products globally.
Its sole business is selling fixed-rate and variable annuity contracts. Island Life maintains
accounting records in U.S. dollars (USD) and segments its fixed-rate and variable contract assets
into separate investment portfolios to better match assets and liabilities.
Both fixed-rate and variable contracts have surrender clauses. The clauses allow the owner to
terminate the contract for the original investment plus accrued earnings at the two-year
anniversary of the contract. After the two-year period, the contracts cannot be surrendered for
the remainder of the original term.
Island Life’s fixed-rate annuities are sold with an initial 10-year term. Earning rates are
guaranteed and are based on the 10-year U.S. Treasury bond yield at the time the contract is sold.
Island Life invests its fixed-rate portfolio in government bonds issued by G7 countries and
investment grade corporate bonds. Island Life currently has a small surplus in its fixed rate
business. The weighted average duration of the assets is lower than the weighted average
duration of the liabilities. Island Life’s economist forecasts that global interest rates will rise
over the next two years.
Island Life’s variable annuity products are sold with an initial 20-year term. These contracts pay
a return at maturity based on one of several global stock market index returns over that period.
Island Life pays its corporate tax liabilities at year end. Local tax regulations require:
• insurance companies that consolidate investment portfolios to pay a 10% tax on

realized gains from equity investments;
• insurance companies that segment investment portfolios to pay a 10% tax on
income and realized gains from all investments.

LEVEL III
Question: 2
Minutes: 25
A. Determine the effect (increase, no change, decrease) on each of the following

characteristics of the fixed-rate portfolio if Island Life’s global interest rate forecast is
correct:
i. surplus
ii. reinvestment risk
iii. expected surrender rate
Justify each response with one reason.
ANSWER QUESTION 2-A IN THE TEMPLATE PROVIDED ON PAGE 15.
(9 minutes)
B. Identify two of Island Life’s investment policy constraints that are affected by the
surrender clause. Explain how each constraint is affected.
(6 minutes)
Kyle Stewart manages Island Life’s fixed-rate portfolio. Stewart previously managed a fixed
income portfolio during a period of rising interest rates. The portfolio experienced large losses
that took years to recover.
Global interest rates have ranged from 0.4 to 0.8 times the historical average over the past two
years. Based on this information, Stewart forecasts interest rates to rise into a narrow band
between 1.15 and 1.20 times the historical average. As a result, Stewart reallocates the fixed-rate
portfolio assets to a very short duration relative to the duration of Island Life’s fixed-rate
liabilities. The government bond portion of Stewart’s portfolio reflects his longstanding
preference to equally weight all G7 countries.
In the months since he first moved to a short duration strategy, market interest rates have
consistently decreased. Stewart continues to maintain his interest rate forecast and portfolio
strategy. He states:
“The primary objective of Island Life’s fixed income portfolio is to avoid

potential interest rate risk. Since our fixed-rate portfolio is currently at only a 5%
surplus, a short duration strategy relative to our fixed-rate liabilities is necessary
to prevent a shortfall.”

LEVEL III
Question: 2
Minutes: 25
C. Explain how Stewart exhibits each of the following behavioral biases:
i. gambler’s fallacy
ii. naïve diversification
iii. regret
(6 minutes)
D. Describe two examples of Stewart’s behavioral bias of overconfidence.
(4 minutes)

LEVEL III
Question: 2
Minutes: 25
Template for Question 2-A

Determine the effect
(increase, no change,
decrease) on each of
the following
characteristics of the
Characteristic Justify each response with one reason.
fixed-rate portfolio if
Island Life’s global
interest rate forecast
is correct.
(circle one)
Increase
i. surplus No change
Decrease
Increase
ii. reinvestment
No change
risk
Decrease
Increase
iii. expected
No change
surrender rate
Decrease

LEVEL III
Question: 2
Minutes: 25
Reading References:
“Managing Institutional Investor Portfolios,” Ch. 3, Managing Investment Portfolios: A Dynamic
Process, 3rd edition, R. Charles Tschampion, Laurence B. Siegel, Dean J. Takahashi, and
John L. Maginn (CFA Institute, 2007).
“Heuristic-Driven Bias: The First Theme,” Ch. 2, Beyond Greed and Fear: Understanding
Behavioral Finance and the Psychology of Investing, Hersh Shefrin (Oxford University
Press, 2002).
“Frame Dependence: The Second Theme,” Ch. 3, Beyond Greed and Fear: Understanding
Press, 2002).
“Inefficient Markets: The Third Theme,” Ch. 4, Beyond Greed and Fear: Understanding
Press, 2002).
“Portfolios, Pyramids, Emotions, and Biases,” Ch.10, Beyond Greed and Fear: Understanding
Press, 2002).
Purpose:
To test knowledge and use of investment policies for insurance companies and general
behavioral finance issues as they relate to institutional investors.
LOS: 2010-III-20-j,l,m
“Managing Institutional Investor Portfolios”
The candidate should be able to
a) contrast a defined-benefit plan to a defined-contribution plan, from the perspective of the
employee and employer and discuss the advantages and disadvantages of each;
b) discuss investment objectives and constraints for defined-benefit plans;
c) evaluate pension fund risk tolerance when risk is considered from the perspective of the
(1) plan surplus, (2) sponsor financial status and profitability, (3) sponsor and pension fund
common risk exposures, (4) plan features, and (5) workforce characteristics;
d) formulate an investment policy statement for a defined-benefit plan;
e) evaluate the risk management considerations in investing pension plan assets;
f) formulate an investment policy statement for a defined-contribution plan;
g) discuss hybrid pension plans (e.g., cash balance plans) and employee stock ownership
plans;
h) distinguish among various types of foundations, with respect to their description,
purpose, source of funds, and annual spending requirements;
i) compare and contrast the investment objectives and constraints of foundations,
endowments, insurance companies, and banks;
j) formulate an investment policy statement for a foundation, an endowment, an
insurance company, and a bank;
LEVEL III
Question: 2
Minutes: 25
k) contrast investment companies, commodity pools, and hedge funds to other types of
institutional investors;
l) discuss the factors that determine investment policy for pension funds, foundations,
endowments, life and nonlife insurance companies, and banks;
m) compare and contrast the asset/liability management needs of pension funds,
foundations, endowments, insurance companies, and banks;
n) compare and contrast the investment objectives and constraints of institutional investors
given relevant data, such as descriptions of their financial circumstances and attitudes toward
risk.
2010-III-7-a
“Heuristic-Driven Bias: The First Theme”
a) evaluate the impact of heuristic-driven biases on investment decision making,
including representativeness, overconfidence, anchoring-and-adjustment, and
aversion to ambiguity.
2010-III-8-b
“Frame Dependence: The Second Theme”
a) explain how loss aversion can result in investors’ willingness to hold on to
deteriorating investment positions;
b) evaluate the impact that the emotional frames of self-control, regret
minimization, and money illusion have on investor behavior.
2010-III-9-a,b
“Inefficient Markets: The Third Theme”
a) evaluate the impact that representativeness, conservatism (anchoring-and-
adjustment), and frame dependence may have on security pricing and discuss
the implications for market efficiency;
b) discuss the implications of investor overconfidence when trading.
2010-III-10-c
“Portfolios, Pyramids, Emotions, and Biases”
a) discuss the influence of hope and fear on investors’ desire for security and
investment potential;
b) explain how portfolios can be structured as layered pyramids and how such
structures address needs associated with security, potential, and aspiration;
c) evaluate the impact of excessive optimism and overconfidence on investors’
decisions regarding portfolio construction.
LEVEL III
Question: 2
Minutes: 25
Guideline Answer:
PART A
Determine the effect

(increase, no change,
decrease) on each of
the following
characteristics of the
Characteristic Justify each response with one reason.
fixed-rate portfolio if
Island Life’s global
interest rate forecast
is correct.
(circle one)
All else equal, the surplus would increase in a rising
Increase interest rate environment. Given the current
asset/liability structure, i.e., a shorter average duration
of assets versus liabilities, as interest rates increase the
i. surplus value of the assets will decline by less than the value of
No change
the liabilities. Thus, the portfolio surplus would
increase.
Decrease
Island Life’s annuity contracts are written with
Increase expected rates of return on reinvested income during
the life of the contract. All else equal, rising interest
rates would reduce reinvestment risk since income
ii. reinvestment from the investment portfolio can be reinvested at rates
risk No change
higher than currently available.
Decrease
All else equal, contracts not yet past the surrender date
offer an inferior expected return versus that of
Increase competing investments with higher interest rates.
Annuity owners can be expected to surrender their
iii. expected current contracts to reinvest in competing investments
surrender rate offering higher yields.
No change
Decrease
LEVEL III
Question: 2
Minutes: 25
PART B
The surrender clause creates the potential for significant changes in time horizon and liquidity
constraints. Potential surrenders at the two-year anniversary would shorten the investment time
horizon and require sufficient liquidity to meet these surrenders.
PART C
Gambler’s Fallacy Stewart’s uses a small sample of observations of below-average

interest rates (two years) to forecast above-average interest rates, thus
expecting a reversion to the mean in the short run, rather than the long
run. This is an example of gambler’s fallacy.
Naïve Diversification Stewart’s preference to equally weight government bonds from all G-
7 countries reflects naïve diversification.
Regret Stewart exhibits the bias of Regret or Regret Avoidance in two

actions. First, Stewart’s previous bad experience managing fixed
income assets in a rising rate environment has undue influence in his
selection of a short duration strategy. In addition, after interest rates
continued to decrease, resulting in underperformance, Stewart decides
to maintain his current strategy.
PART D
Stewart’s forecasting and decision making reflect the behavioral bias of overconfidence in the
following ways:
• The narrow range of potential outcomes in his forecast.

• His decision to maintain his forecast as additional information emerges. This
anchoring around his initial expectations reflects his overconfidence in his
forecast and forecasting abilities.
• His failure to include other factors, such as a non-parallel shift in the yield curve
or a change in spreads between different types of bonds, that can affect the
portfolio’s surplus.

LEVEL III
Question: 3
Topic: Institutional (Pension)
Minutes: 24
QUESTION 3 HAS TWO PARTS (A, B) FOR A TOTAL OF 24 MINUTES.
Ed Schlipp is a pension fund consultant. Clients include Apax Bakers, CarbX Corp, and
DataComp. He works with all clients to link assets and liabilities for their respective pension
plans.
Apax is a major supplier of bread to retailers and restaurants. Apax generates all of its revenues
in the U.S. and has been profitable in recent years. The outlook for future profitability of the
company is positive.
Apax operates a defined benefit pension plan with 1 billion U.S. dollars (USD) in assets. Strong
investment performance created a pension surplus of USD 95 million. The Apax pension plan
has a growing ratio of inactive to active members and is now closed to new participants. Plan
benefits are not inflation indexed.
A. Identify three factors that affect Apax pension plan’s ability to take risk. Determine
whether each factor increases or decreases the plan’s ability to take risk. Justify each
response with one reason.
ANSWER QUESTION 3-A IN THE TEMPLATE PROVIDED ON PAGE 22.
(12 minutes)
CarbX Corp is an unprofitable U.S.-based producer of automobile engine components. Its

defined benefit pension plan has been in deficit for 10 years. A recent agreement between the
company and the participants of the CarbX pension plan resulted in the plan being frozen in
exchange for CarbX making a one-time payment to fully fund the plan. The plan has a high ratio
of inactive to active participants and plan benefits are not inflation indexed.
DataComp is a growing and profitable U.S.-based software company that markets its products
globally. Its defined benefit pension plan was recently established and has a surplus. The plan
has no inactive participants and is open to future participants. Plan benefits are not inflation
indexed.
Schlipp has gathered data on the current asset allocation for each of the three pension plans,
which are shown in Exhibit 1.

LEVEL III
Question: 3
Minutes: 24
Exhibit 1
Current Pension Plan Asset Allocations
Apax CarbX
Asset Class DataComp
Bakers Corp
Nominal bonds 90% 90% 60%
Real rate bonds 10% 0% 20%
Equity 0% 10% 20%
Schlipp’s recommendation for all three clients is to create an asset portfolio that better mimics
liabilities. He examines various potential trades (shown in Exhibit 2) to achieve this
recommendation.
Exhibit 2
Potential Trades
Trade Sell Buy
A 10% nominal bonds 10% real rate bonds
B 10% nominal bonds 10% equity
C 10% real rate bonds 10% nominal bonds
D 10% real rate bonds 10% equity
E 10% equity 10% nominal bonds
F 10% equity 10% real rate bonds
B. Determine, from the potential trades in Exhibit 2, which trade would be most appropriate
to achieve Schlipp’s recommendation for each company:
i. Apax Bakers (Trade A, B, C, or D)

ii. CarbX Corp (Trade A, B, E, or F)
iii. DataComp (Trade B, C, E, or F)
Justify each response with one reason.
ANSWER QUESTION 3-B IN THE TEMPLATE PROVIDED ON PAGE 23.
(12 minutes)

LEVEL III
Question: 3
Minutes: 24

Determine whether
each factor
Identify three factors that
increases or
affect Apax pension plan’s Justify each response with one reason.
decreases the plan’s
ability to take risk.
(circle one)
increases
1.
decreases
increases
2.
decreases
increases
3.
decreases

LEVEL III
Question: 3
Minutes: 24
Template for Question 3-B

Determine, from the
potential trades in
Exhibit 2, which
trade would be most
Company appropriate to Justify each response with one reason.
achieve Schlipp’s
recommendation for
each company.
(circle one)
Trade A
Trade B
i. Apax Bakers
Trade C
Trade D
Trade A
Trade B
ii. CarbX Corp
Trade E
Trade F
Trade B
Trade C
iii. DataComp
Trade E
Trade F
LEVEL III
Question: 3
Minutes: 24
Reading References:
2010 Level III, Volume 2, Study Session 5, Reading 20, pp 366-382
“Managing Institutional Investor Portfolios,” Managing Investment Portfolios: A Dynamic
Process, 3rd edition, R. Charles Tschampion, CFA, Laurence B. Siegel, Dean J. Takahashi, and
John L. Maginn, CFA (CFA Institute, 2007)
2010 Level III, Volume 2, Study Session 5, Reading 21, pp 455-470

“Linking Pension Liabilities to Assets,” Aaron Meder and Renato Staub (UBS Global
Asset Management, 2006)
Purpose: To test knowledge and understanding of various aspects of risk as it relates to defined
benefit pension plans.
LOS: 2010-III-20
20. “Managing Institutional Investor Portfolios”
a) contrast a defined-benefit plan to a defined-contribution plan, from the perspective
of the employee and employer and discuss the advantages and disadvantages of
each;
b) discuss investment objectives and constraints for defined-benefit plans;
c) evaluate pension fund risk tolerance when risk is considered from the
perspective of the (1) plan surplus, (2) sponsor financial status and
profitability, (3) sponsor and pension fund common risk exposures, (4) plan
features, and (5) workforce characteristics;
d) formulate an investment policy statement for a defined-benefit plan;
e) evaluate the risk management considerations in investing pension plan assets;
f) formulate an investment policy statement for a defined-contribution plan;
g) discuss hybrid pension plans (e.g., cash balance plans) and employee stock
ownership plans;
h) distinguish among various types of foundations, with respect to their description,
purpose, source of funds, and annual spending requirements;
i) compare and contrast the investment objectives and constraints of foundations,
endowments, insurance companies, and banks;
j) formulate an investment policy statement for a foundation, an endowment, an
insurance company, and a bank;
k) contrast investment companies, commodity pools, and hedge funds to other types of
institutional investors;
l) discuss the factors that determine investment policy for pension funds, foundations,
endowments, life and nonlife insurance companies, and banks;

LEVEL III
Question: 3
Minutes: 24
m) compare and contrast the asset/liability management needs of pension funds,

foundations, endowments, insurance companies, and banks;
o) compare and contrast the investment objectives and constraints of institutional
investors given relevant data, such as descriptions of their financial circumstances
and attitudes toward risk.
LOS: 2010-III-21
21. “Linking Pension Liabilities to Assets”
a) contrast the assumptions concerning pension liability risk in asset-only and liability-
relative approaches to asset allocation;
b) discuss the fundamental and economic exposures of pension liabilities and identify
asset types that mimic these liability exposures;
c) compare pension portfolios built from a traditional asset-only perspective to portfolios
designed relative to liabilities and discuss why corporations may choose not to implement
fully the liability mimicking portfolio.

LEVEL III
Question: 3
Minutes: 24
Guideline Answer:
PART A

NOTE: Three factors are required but there are five possible answers.
Determine whether
each factor
Identify three factors that
increases or
affect Apax pension plan’s Justify each response with one reason.
decreases the plan’s
(circle one)
Apax’s pension plan has a USD95 surplus. The
increases plan can experience some level of negative
1. Pension surplus returns without jeopardizing the coverage of
plan liabilities. This allows the plan to take
decreases greater risk.
Apax is profitable and the outlook is positive. A
increases financially strong sponsor has a higher ability to
2. Company profitability fund potential shortfalls than a financially weak
sponsor.
decreases
A closed plan will not be adding younger
participants. A plan with increasing average age
increases will have shorter duration liabilities and higher
3. Pension plan is closed
to new participants liquidity requirements, implying lower risk
tolerance.
decreases
The higher the proportion of inactive to active

4. A growing ratio of members, the shorter the duration of the plan’s
increases
inactive to active plan liabilities. Shorter duration liabilities imply
members lower risk tolerance.
decreases
In an inflationary environment, a plan not
inflation-indexed would most likely grow its
nominal asset base faster than its pension
increases
5. No inflation indexing liability as payments to current retirees will not
increase. Lower liabilities, as compared with a
decreases
plan with inflation indexed benefits, allows the
plan to take greater risk.
LEVEL III
Question: 3
Minutes: 24
PART B
Determine, from the

potential trades in
Exhibit 2, which
trade would be most
Company appropriate to Justify each response with one reason.
achieve Schlipp’s
recommendation for
each company.
(circle one)
Active members in the Apax plan will likely see
future wage growth. Since the inflation component of
wage growth is highly correlated with returns on real
Trade A
rate bonds, Apax should retain its real rate bond
holdings.
Trade B
i. Apax Bakers
Future real wage growth is best mimicked by equities
Trade C
which are not present in the current portfolio. The
sale of some nominal bonds and purchase of equities
Trade D
would add this liability mimicking asset into the mix.
The CarbX pension plan is frozen, so there is no need

for equity. Because there is no inflation indexation,
Trade A the accrued benefit liability is the ultimate liability of
the plan. This liability can be mimicked entirely with
Trade B nominal bonds. This is accomplished by a sale of
ii. CarbX Corp
equities and purchase of nominal bonds.
Trade E
Trade F
DataComp’s pension plan is new with no inactive

members minimal accrued benefits. This greatly
Trade B reduces the need for nominal bonds. As the plan is in
surplus, and the company is profitable and growing, a
Trade C higher weighting in equities is appropriate to better
iii. DataComp
mimic future real wage growth.
Trade E
Trade F

LEVEL III
Question: 4
Topic: Economics
Minutes: 14
QUESTION 4 HAS THREE PARTS (A, B, C) FOR A TOTAL OF 14 MINUTES.
Francisco Martin and Emma Liu are analysts at the same firm. Martin uses the cyclical indicator
approach to formulate his equity market outlook, whereas Liu uses microvaluation analysis to
develop her equity market outlook. Martin and Liu have conflicting views on the current outlook
for the U.S. equity market.
Martin prepares Exhibit 1, a table of recent values of selected U.S. cyclical indicators. He makes
the following observation: “Several leading indicators suggest further deterioration in economic
conditions. Based on the cyclical indicator approach, these developments are clearly unfavorable
for the U.S. equity market.”
Exhibit 1
Selected U.S. Cyclical Indicators
Value as of Value as of
Indicator 31 December 31 March
2009 2010
Average duration of unemployment (weeks) 18.1 18.2
Average prime rate 5.0% 5.0%
Average weekly hours of manufacturing workers 40.3 39.2
Index of consumer expectations 59.8 49.2
Labor cost per unit of output, manufacturing 124.1 125.3
Index of new private housing starts authorized by local building permits 2429 2120
Manufacturing and trade sales (in U.S. dollar billions) 989 920
Ratio of consumer installment credit outstanding to personal income 0.175 0.186
Consumer price index (inflation rate) for services 217.7 216.8
Interest rate spread, 10-year Treasury bonds less federal funds rate 2.22% 2.45%
A. Identify two leading cyclical indicators in Exhibit 1 that support Martin’s observation
regarding the U.S. equity market. Explain how the change in value of each of these
indicators supports Martin’s observation.
(6 minutes)
B. Describe two general limitations of Martin’s approach to formulating an equity market

outlook.
(4 minutes)

LEVEL III
Question: 4
Topic: Economics
Minutes: 14
Liu responds to Martin’s observation: “The economy appears to be weakening, but I believe this
has already been priced into the market. The S&P 500 Index is currently at 760. Inflation is low
and corporate earnings of the S&P 500 Index constituents are $51.80. The dividend yield (on a
trailing annual basis) is 3.5% and I expect the dividend growth rate to be constant at 5%. With
the risk-free rate at 2%, if I assume a 6% equity risk premium, both the dividend discount model
and the earnings multiplier approach indicate that the equity market is undervalued at these
levels.”
C. Calculate the intrinsic value of the S&P 500 Index using the constant growth dividend
discount model of market valuation and the information provided by Liu. Show your
calculations.
(4 minutes)

LEVEL III
Question: 4
Topic: Economics
Minutes: 14
Reading References:
2010 Level III, Volume 3, Study Sessions 6 – 7
23. “Capital Market Expectations,” Ch. 4, Managing Investment Portfolios: A Dynamic
Process, 3rd edition, John P. Calverley, Alan M. Meder, Brian D. Singer, and Renato
Staub (CFA Institute, 2007).
24. “Macroanalysis and Microvaluation of the Stock Market,” Ch. 12, Investment Analysis
and Portfolio Management, 8th edition, Frank K. Reilly and Keith C. Brown (South
Western, 2006).
LOS: 2010-III-6-23-e,f
23. “Capital Market Expectations”
a) discuss the role of, and a framework for, capital market expectations in the portfolio
management process;
b) discuss, in relation to capital markets expectations, the limitations of economic data,
data measurement errors and biases, the limitations of historical estimates, ex post
risk as a biased measure of ex ante risk, biases in analysts’ methods, the failure to
account for conditioning information, the misinterpretation of correlations,
psychological traps, and model uncertainty;
c) demonstrate the application of formal tools for setting capital market expectations,
including statistical tools, discounted cash flow models, the risk premium approach,
and financial equilibrium models;
d) explain the use of survey and panel methods and judgment in setting capital market
expectations;
e) discuss the inventory and business cycles, the impact of consumer and business
spending, and monetary and fiscal policy on the business cycle;
f) discuss the impact that the phases of the business cycle have on short-
term/long-term capital market returns;
g) explain the relationship of inflation to the business cycle and the implications of
inflation for cash, bonds, equity, and real estate returns;
h) demonstrate the use of the Taylor rule to predict central bank behavior;
i) evaluate (1) the shape of the yield curve as an economic predictor and (2) the
relationship between the yield curve and fiscal and monetary policy;
j) identify and interpret the components of economic growth trends and demonstrate
the application of economic growth trend analysis to the formulation of capital
market expectations;
k) discuss the risks faced by investors in emerging-market securities and the country
risk analysis techniques used to evaluate emerging market economies;
l) identify and interpret macroeconomic and interest and exchange rate links between
economies;
m) compare and contrast the major approaches to economic forecasting;
LEVEL III
Question: 4
Topic: Economics
Minutes: 14
n) demonstrate the use of economic information in forecasting asset class returns;
o) evaluate how economic and competitive factors affect investment markets, sectors,
and specific securities;
p) identify and interpret the major approaches to forecasting exchange rates;
q) recommend and justify changes in the component weights of a global investment
portfolio based on trends and expected changes in macroeconomic factors.
LOS: 2010-III-7-24-a,c
24. “Macroanalysis and Microvaluation of the Stock Market”
a) contrast leading, lagging, and coincident economic indicators and explain the
relationship between these cyclical indicator categories and stock market
valuation;
b) demonstrate how changes in money supply, inflation, and interest rates influence
stock and bond prices;
c) demonstrate the use of the dividend discount model, the free cash flow to
equity model, and the earnings multiplier approach in estimating the value of
the aggregate stock market;
d) compare and contrast alternative approaches with the estimation of earnings per
share;
e) formulate and explain the “direction of change” and the “specific estimate”
approaches to estimating an earnings multiplier for a stock market series;
f) evaluate the intrinsic value and estimated rate of return of the stock market by
estimating future earnings per share and determining an appropriate earnings
multiplier.

LEVEL III
Question: 4
Topic: Economics
Minutes: 14
Guideline Answer:
PART A
There are three leading cyclical indicators in Exhibit 1 that support Martin’s observation:
1. Average weekly hours of manufacturing workers

2. Index of consumer expectations
3. Index of new private housing starts authorized by local building permits
The only other leading indicator is Interest rate spread. The widening of the spread over the last
three months does not support Martin’s observation about the direction of the economy, since it
indicates that the yield curve has steepened. A flattening yield curve would be indicative of a
weakening economy.
The other indicators in Exhibit 1 are coincident or lagging indicators.
A leading economic indicator (LEI) is an economic time series that varies with the business
cycle, but at a fairly consistent time interval before a turn in the business cycle. LEIs usually
reach peaks or troughs before corresponding peaks or troughs in aggregate economic activity.
Analysts are interested in LEIs because they may provide information about upcoming changes
in economic activity, inflation, interest rates, and security prices.
The leading indicators referenced by Martin focus on business activity and consumer sentiment
and activity. Each indicator shows a decrease during the quarter, suggesting that the economy is
weakening. The weakening economy should have a negative effect on equity market returns as
expectations are priced into the market.
PART B
Limitations of the Cyclical Indicator Approach are as follows:
• False Signals – This occurs when a series that is moving in one direction suddenly
reverses and nullifies a prior signal, or hesitates, which is difficult to interpret.
• Currency of the Data and Revisions – Some data series are reported with a lag.
Also, revisions in data can change the magnitude of the signal, and even change
the direction implied by the original data.
• Economic Sectors Not Reported – Examples include the service sector, import-
exports, and many international series.
• Changes in Relationships among Economic Variables – unstable relationships
might invalidate assumptions about the effects of changes in a variable.
LEVEL III
Question: 4
Topic: Economics
Minutes: 14
PART C
The dividend discount model formula is defined as follows:
P = D1 / (k-g)
Where:
P = intrinsic value
D0 = current dividend rate
D1 = dividend rate in period 1
g = constant growth rate of dividends
k = the required rate of return for stock market (risk free rate + equity risk premium)
Calculate D1 = D0 * (1+g):
D1 = (760*.035)*(1+.05)
=27.93
Calculate k-g:
k-g = (.02+.06)-(.05)
=.03
DDM:
D1 / (k-g) = 27.93 / .03 = 931

LEVEL III
Question: 5
Topic: Asset Allocation
Minutes: 15
QUESTION 5 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 15 MINUTES.
Bill Tubduhl is a consultant to the board of directors of the U.S.-based Thompson Foundation.
The board asks Tubduhl to recommend an asset allocation for Thompson. Tubduhl reviews key
objectives of the Thompson investment policy statement shown in Exhibit 1.
Exhibit 1
Thompson Foundation
Key Objectives of Investment Policy Statement
Return objective:
• Required annual rate of return on investment portfolio is 9.6%.
Risk objectives:
• Diversify the portfolio consistent with prudent investment practices.
• Minimize portfolio risk while achieving return objective.
• Leverage is not allowed.
For the strategic asset allocation analysis, Tubduhl has generated the corner portfolios shown in
Exhibit 2.
Exhibit 2
Corner Portfolios
(Risk-free Rate = 3.0%)
Asset Class Portfolio Weights (%)
Annual
Annual Inter-
Corner Expected Long-
Expected Sharpe Non- mediate- Non-
Portfolio Standard U.S. term Real
Return Ratio U.S. term U.S.
Number Deviation Equities U.S. Estate
(%) Equities U.S. Bonds
(%) Bonds
Bonds
1 10.9 16.3 0.48 100.0 0.0 0.0 0.0 0.0 0.0
2 10.5 14.7 0.51 82.4 0.0 0.0 0.0 0.0 17.6
3 10.2 13.7 0.53 74.1 4.0 0.0 0.0 0.0 21.9
4 9.4 10.1 0.63 33.7 12.0 36.7 0.0 0.0 17.6
5 8.8 8.6 0.67 31.4 12.0 26.7 13.0 0.0 16.9
6 8.2 7.3 0.71 25.0 11.8 0.0 45.3 3.4 14.5
7 6.9 5.3 0.74 0.0 13.7 0.0 53.0 27.1 6.2
8 6.4 4.9 0.69 0.0 11.2 0.0 53.0 31.5 4.3

LEVEL III
Question: 5
Minutes: 15
Answer Questions 5-A, 5-B, and 5-C using mean-variance analysis:
A. Select the two adjacent corner portfolios to be used in finding the most appropriate
strategic asset allocation for Thompson’s investment portfolio.
(3 minutes)
B. Determine the most appropriate allocation between the two adjacent corner portfolios
selected in Part A.
(3 minutes)
C. Determine the percentage that would be invested in real estate based on the most
appropriate strategic asset allocation.
(3 minutes)
Tubduhl also advises Jack Slifer, a U.S. investor, who is considering the addition of high yield
bonds to his portfolio. Based on Tubduhl’s research, U.S. high yield bonds have an expected
return of 6.5%, an expected standard deviation of 10.5%, and a predicted correlation with Slifer’s
portfolio of 0.6. Slifer’s portfolio has a Sharpe ratio of 0.46. The risk-free rate is 3.0%.
D. Determine, based on the Sharpe ratio criterion, if Tubduhl should include U.S. high yield
bonds in Slifer’s portfolio. Justify your response with one reason. Show your
calculations.
(3 minutes)
At his next meeting with Slifer, Tubduhl proposes adding Chinese equities to the portfolio. The
expected return on Chinese equities is 14.0% with an expected standard deviation of 23.5% (both
in local currency). The expected standard deviation of the U.S. dollar/Chinese yuan exchange
rate is 6.0% and the predicted correlation between Chinese equity returns in local currency and
exchange rate movements is 0.2.
E. Calculate the risk of Slifer’s investment in Chinese equities measured in U.S. dollar
terms. Show your calculations.
(3 minutes)

LEVEL III
Question: 5
Minutes: 15
Reading References:
“Asset Allocation,” Ch. 5, Managing Investment Portfolios: A Dynamic Process, 3rd edition,
William F. Sharpe, Peng Chen, Jerald E. Pinto, and Dennis W. McLeavey (CFA Institute, 2007)
“The Case for International Diversification,” Ch. 9, Global Investments, 6th edition, Bruno Solnik
and Dennis McLeavey (Addison Wesley, 2008)
Purpose:
To test the candidate’s ability to determine an appropriate asset allocation for an investor.
LOS: 2010-III-8-26- g, h, I, j, m, n, o

a) summarize the function of strategic asset allocation in portfolio management and
discuss its role in relation to specifying and controlling the investor’s exposures to
systematic risk;
b) compare and contrast strategic and tactical asset allocation;
c) appraise the importance of asset allocation for portfolio performance;
d) contrast the asset-only and asset/liability management (ALM) approaches to asset
allocation;
e) explain the advantage of dynamic over static asset allocation and evaluate the trade-
offs of complexity and cost;
f) explain how loss aversion, mental accounting, and fear of regret may influence asset
allocation policy;
g) evaluate return and risk objectives in relation to strategic asset allocation;
h) evaluate whether an asset class or set of asset classes has been appropriately
specified;
i) select and justify an appropriate set of asset classes for an investor;
j) evaluate the theoretical and practical effects of including additional asset classes
in an asset allocation;
k) formulate and implement the major steps in asset allocation;
l) discuss the strengths and limitations of the following approaches to asset allocation:
mean–variance, resampled efficient frontier, Black–Litterman, Monte Carlo
simulation, ALM, and experience based;
m) discuss the structure of the minimum-variance frontier with a constraint against
short sales;
n) formulate and justify a strategic asset allocation, given an investment policy
statement and capital market expectations;

LEVEL III
Question: 5
Minutes: 15
o) contrast the characteristic issues relating to asset allocation for individual investors
versus institutional investors and critique a proposed asset allocation in light of those
issues;
p) formulate and justify tactical asset allocation (TAA) adjustments to strategic asset-
class weights, given a TAA strategy and expectational data

LEVEL III
Question: 5
Minutes: 15
LOS: 2010-III-8-27-b, c, f

a) evaluate the implications of international diversification for domestic equity and
fixed income portfolios, based on the traditional assumptions of low correlations
across international markets;
b) distinguish between the asset return and currency return for an international
security;
c) evaluate the contribution of currency risk to the volatility of an international
security position;
d) explain and justify the impact of international diversification on the efficient frontier;
e) evaluate the potential performance and risk-reduction benefits of adding bonds to a
globally diversified stock portfolio;
f) explain why currency risk should not be a significant barrier to international
investment;
g) critique the traditional case against international diversification;
h) discuss the barriers to international investments and their impact on international
investors;
i) distinguish between global investing and international diversification and discuss the
growing importance of global industry factors as a determinant of risk and
performance;
j) summarize the basic case for investing in emerging markets, as well as the risks and
restrictions often associated with such investments.

LEVEL III
Question: 5
Minutes: 15
Guideline Answer:
PART A
Corner portfolios 3 and 4 are the corner portfolios to be used in determining the most appropriate
strategic asset allocation for the Thompson Foundation.
The portfolio that satisfies Thompson’s return and risk objectives must lie on the portion of the
efficient frontier located between corner portfolio 3 and corner portfolio 4.
PART B
Using the corner portfolio theorem and the expected returns for corner portfolio 3 and corner
portfolio 4, solve the following equation for w:
9.6 = 10.2w + 9.4(1 – w)

The solution yields:
w = 0.25 and 1 – w = 0.75
where w represents the weight allocated to corner portfolio 3.
Therefore, most appropriate strategic asset allocation is 25% in corner portfolio 3 and 75% in
corner portfolio 4.
PART C
The percent age invested in real estate given the most appropriate allocation equals the weighted
average of the real estate allocations in corner portfolios 3 and 4:
Real estate weight = 0.25 × 21.9% + 0.75 × 17.6% = 18.675% ≈ 18.7%.
PART D
In order to achieve a superior portfolio of risky assets by adding high-yield U.S. bonds, the
Sharpe ratio for the high yield bonds must exceed the product of Slifer’s existing portfolio and
the correlation of the high-yield bonds with the current portfolio. Therefore, U.S. high yield
bonds should be added because the asset class Sharpe ratio = (.065 - .03)/.105 = 0.33 is higher
than the Sharpe ratio of the existing portfolio multiplied by the correlation between the new asset
class and the existing portfolio (.46 ×.60) = .28.

LEVEL III
Question: 5
Minutes: 15
PART E
The risk of an investment in Chinese equities measured in U.S. Dollar terms is measured by the
standard deviation of returns, 25.4%.
This is calculated as follows:
The variance of the returns on foreign asset in U.S. Dollar terms = variance of foreign asset in
local currency + Variance of the exchange rate + (2 × correlation between Foreign asset return
and exchange rate movement × standard deviation of foreign asset in local currency × standard
deviation of the exchange rate)
As given in the problem:
The standard deviation of Chinese equities (in Yuan) = 23.5%

The standard deviation of U.S. Dollar/Chinese Yuan exchange rate = 6%
The correlation between foreign asset return and exchange rate movement = 0.2
Therefore, the variance = (23.5%)2 + (6%)2 + (2 × 0.2 × 23.5% × 6%) = 644.7%2 and the
Standard deviation = 25.4%.

LEVEL III
Question: 6
Topic: Fixed Income
Minutes: 18
George Frost is a portfolio manager at ALIAB Bank, which has just issued a guaranteed
investment contract (GIC). He needs to immunize this GIC, which guarantees a single payment
of 80,000,000 U.S. dollars (USD) in 4 years and provides a bond equivalent yield of
approximately 3.50%. Frost calculates the present value of the GIC to be USD 69,640,000. This
is the amount he intends to invest today to immunize the GIC. He is not permitted to use
leverage.
Frost is building a suitable portfolio and already holds the U.S. government bonds shown in
Exhibit 1.
Exhibit 1
Existing Portfolio Bonds
Market Total Total
Bond Price Market Value Dollar
(USD) (USD) Duration
Bond A 102.32 24,556,800 477,139
Bond B 94.90 29,815,000 2,104,939
Frost must choose a U.S. government bond to complete the immunized portfolio. He has
gathered the data shown in Exhibit 2.
Exhibit 2
Bonds Available to Complete Immunized Portfolio
Market
Yield to Modified
Bond Price
Maturity Duration
(USD)
Bond X 99.97 3.52% 1.333
Bond Y 99.36 3.80% 2.154
Bond Z 99.35 3.85% 1.890
A. Determine which bond (X, Y, or Z) is the most suitable for Frost to complete the
immunized portfolio. Justify your response with one reason. Show your calculations.
(8 minutes)
A client of Frost, Farm Technology (FT), has entered into a transaction requiring a payment of
USD 250,000,000 in two years. FT has USD 235,000,000 available to meet this liability.

LEVEL III
Question: 6
Topic: Fixed Income
Minutes: 18
Frost recommends a technique called contingent immunization. Under certain market

conditions, this technique can provide FT with a safety margin or cushion in meeting its liability.
He notes that a U.S. government bond with a bond equivalent yield of 3.82% is available. FT
agrees to implement contingent immunization using this bond.
B. i. Determine the initial dollar safety margin. Show your calculations.

ii. Identify the main advantage to FT of using contingent immunization rather than
classical immunization.
(6 minutes)
Frost discusses other opportunities to use immunization with Victor Smith, a financial manager
at FT. Smith makes the following statements:
Statement 1: “FT should use corporate bonds for immunization in the future as this will
achieve a lower cost of immunization.”
Statement 2: “Whenever FT implements a multiple-liability immunization plan, the market

value of the assets should be compared with the present value of the remaining
liabilities by discounting the liabilities using zero coupon U.S. Treasury yields.”
C. Explain why each of Smith’s statements is incorrect.
Note: Simply reversing the statements will receive no credit.
(4 minutes)

LEVEL III
Question: 6
Topic: Fixed Income
Minutes: 18
Reading References:
28. “Fixed-Income Portfolio Management-Part I,” Ch. 6, sections 1–4 (pp. 1–40) Managing
Investment Portfolios: A Dynamic Process, 3rd edition, H. Gifford Fong and Larry D.
Guin (CFA Institute, 2007).
Purpose:
To test understanding of single liability immunization and contingent immunization. To test
application considerations for construction of immunized and cash flow matched portfolios.
LOS: 2010-III-9-28-f-m
Fixed-Income Portfolio Management-Part I

a) compare and contrast, with respect to investment objectives, the use of liabilities as
a benchmark and the use of a bond index as a benchmark;
b) compare and contrast pure bond indexing, enhanced indexing, and active investing
with respect to the objectives, techniques, advantages, and disadvantages of each;
c) discuss the criteria for selecting a benchmark bond index and justify the selection of
a specific index when given a description of an investor’s risk aversion, income
needs, and liabilities;
d) review and justify the means, such as matching duration and key rate durations, by
which an enhanced indexer may seek to align the risk exposures of the portfolio
with those of the benchmark bond index;
e) contrast and illustrate the use of total return analysis and scenario analysis to assess
the risk and return characteristics of a proposed trade.
f) design a bond immunization strategy that will ensure funding of a
predetermined liability and evaluate the strategy under various interest rate
scenarios;
g) demonstrate the process of rebalancing a portfolio to re-establish a desired
dollar duration;
h) explain the importance of spread duration;
i) discuss the extensions that have been made to classical immunization theory,
including the introduction of contingent immunization;
j) critique the risks associated with managing a portfolio against a liability structure,
including interest rate risk, contingent claim risk, and cap risk;
k) compare and contrast immunization strategies for a single liability, multiple
liabilities, and general cash flows;
l) compare and contrast risk minimization with return maximization in
immunized portfolios;

LEVEL III
Question: 6
Topic: Fixed Income
Minutes: 18
m) demonstrate the use of cash flow matching to fund a fixed set of future
liabilities and contrast the advantages and disadvantages of cash flow
matching to those of immunization strategies.

LEVEL III
Question: 6
Topic: Fixed Income
Minutes: 18
Guideline Answer
PART A
There are two approaches that Frost can use to determine the bond that is most suitable to
complete the immunized portfolio, the Dollar Duration Approach and the Modified Duration
Approach.
The Dollar Duration Approach
Under this approach, there are two conditions for an immunized bond portfolio:
1. The dollar duration of the asset portfolio equals the dollar duration of the
liability.
2. The PV of the assets equals the PV of the liabilities.
The dollar duration of the single-pay liability, the GIC, equals USD 2,785,600 and has a present
value of USD 69,640,000.
(USD 69,640,000 x 4 x 0.01 = USD 2,785,600)
Since the present value of the existing bonds in the portfolio is USD 54,371,800, the dollar value
of the most suitable bond must equal USD 15,268,200.
The dollar duration of the existing bonds in the portfolio equals 2,582,078 (477,139 +
2,104,939). The dollar duration of the most suitable bond must be closest to the difference
between the dollar duration of the GIC and the existing bond portfolio, USD 203,522 (USD
2,785,600 - USD 2,582,078).
The dollar durations of the bonds available to complete the immunized portfolio are:
Dollar duration of Bond X = 1.333 x 15,268,200 x 0.01 = 203,525.

Dollar duration of Bond Y = 2.154 x 15,268,200 x 0.01 = 328,877.
Dollar duration of Bond Z = 1.890 x 15,268,200 x 0.01 = 288,569.
Therefore, Frost should complete his immunization process by buying USD 15,268,200 of
Bond X.

LEVEL III
Question: 6
Topic: Fixed Income
Minutes: 18
The Modified Duration Approach
Under this approach, there are two conditions for an immunized bond portfolio:
1. The modified duration of the asset portfolio equals the modified duration of
the liability.
2. The PV of the assets equals the PV of the liabilities.
The single-payment liability (GIC) has a modified duration equal to 4.0 and a present value of
USD 69,640,000. Since the present value of the existing bonds in the portfolio is USD
54,371,800, the dollar value of the most suitable bond must equal USD 15,268,200 and will
constitute 21.92% of the bond portfolio.
The modified durations of the existing bonds in the portfolio are:
Modified duration of Bond A = 477,139 / 24,556,800 / 0.01 = 1.943

Modified duration of Bond B = 2,104,939 / 29,815,000 / 0.01 = 7.060
Since the modified duration of the immunized portfolio, 4.0, equals the weighted average of the
modified durations of the bonds in the portfolio, the most suitable bond must have a modified
duration of 1.333. This is given by:
= [4.0 – (1.943)(0.3526) – (7.060)(0.4281)]/(0.2192) = 1.333

Where:
0.3526 = the portion currently invested in Bond A
0.4281 = the portion currently invested in Bond B
0.2192 = the portion to be invested in most suitable bond
Therefore Frost should complete his immunization process by buying USD 15,268,200 of
Bond X.

LEVEL III
Question: 6
Topic: Fixed Income
Minutes: 18
PART B
i. The government bond yields 3.82%.

FT needs a maturity value of USD 250,000,000 so the amount it needs to invest now is

, ,
= USD 231,778,316.
. /
Therefore the initial dollar safety margin or cushion, is USD 235,000,000 – USD
231,778,316 = USD 3,221,684.
ii. The primary objective of classical immunization is risk control. The main advantage to
FT using contingent immunization is that it provides the flexibility to increase returns.
PART C
Statement 1: Smith is incorrect to state that using corporate bonds will lower the cost of
immunization. Corporate bonds have default risk. Immunization assumes no defaults; using
corporate bonds could raise the cost of immunization. Corporate bonds are also less liquid and
subject to credit spread risk which can increase the cost of rebalancing, which would also
increase the cost of immunization.
Statement 2: Smith is incorrect to state that the liabilities should be discounted using zero-
coupon Treasury rates. Liabilities should be discounted by the internal rate of return on the
immunized portfolio.

LEVEL III
Question: 7
Topic: Risk
Minutes: 20
Chantal Jacob is a portfolio manager in the U.K. The U.K. has bid to be the host country for a
major international sports tournament. The host country will be announced in three weeks.
Jacob believes that the share price of Severn Hospitality plc, a hotel operating company, will be
significantly influenced by the outcome of the bid to host the tournament. If the U.K. is selected,
she believes that Severn’s share price would rise significantly. If the U.K. is not selected, she
believes that Severn’s share price would fall significantly. Jacob wants to profit from her beliefs
by implementing a straddle. She gathers the information shown in Exhibit 1.
Exhibit 1
Severn Hospitality plc Share and Options Data
(GBP = British pound)
Current share price of Severn Hospitality plc GBP 8.80
Annual risk-free rate 1.50%
Price of one month call option, exercise price GBP 9.00 GBP 0.38
Price of one month put option, exercise price GBP 9.00 GBP 0.57
A. Determine each of the following:
i. the profit per share on the straddle if the U.K. wins the bid and Severn’s share
price doubles.
ii. the two share prices of Severn at which breakeven for the straddle occurs.
Show your calculations.
(4 minutes)
B. Explain why each of the following option strategies is less appropriate than a straddle,
given Jacob’s beliefs:
i. bull spread
ii. short butterfly spread
iii. zero cost collar
(6 minutes)

LEVEL III
Question: 7
Topic: Risk
Minutes: 20
Jacob manages the equity portion of the Bold Beverages Pension Fund, which is converting its
pension plan from defined benefit to defined contribution, effective three months from now.
Plan participants have three months to elect various investments for the new plan. The trustees
inform Jacob that they wish to keep the value of the pension fund stable during these three
months.
Accordingly, Jacob wants to eliminate systematic risk in the equity portion of the fund by using
futures on the FTSE 100 Index, which is the benchmark for the fund’s equity portfolio. She
collects the information shown in Exhibit 2.
Exhibit 2
Bold Beverages Pension Fund and Market Data
Value of Bold Beverages Pension Fund equity portfolio GBP 235,400,000
Level of FTSE 100 Index 4,650
Level of three-month FTSE 100 futures contract 4,667
Futures multiplier GBP 10
Beta of Bold Beverages Pension Fund equity portfolio 1.04
Beta of FTSE 100 futures contract 0.98
C. i. State the target beta for Jacob’s hedging strategy.

ii. Determine the number of futures contracts that Jacob should sell to achieve the
target. Show your calculations.
(5 minutes)
Three months after Jacob implements the hedge, the FTSE 100 Index is up 3.75%. The equity
portion of the Bold Beverages Pension Fund is up 3.50% and the level of the expiring three-
month FTSE 100 futures contract that Jacob sold is 4,824. The trustees ask Jacob to assess the
effectiveness of the hedge that has been in place.
D. Determine the effective beta of the Bold Beverages Pension Fund equity portfolio,
including the futures, assuming that Jacob sold 5,200 futures contracts. Show your
calculations.
(5 minutes)

LEVEL III
Question: 7
Topic: Risk
Minutes: 20
Reading References:
41. “Risk Management Applications of Forward and Futures Strategies,” Ch. 6 (pp. 356–391)
Analysis of Derivatives for the CFA® Program, Don M. Chance (AIMR, 2003).
42. “Risk Management Applications of Option Strategies,” Ch. 7 (pp. 430–484), Analysis of
Derivatives for the CFA® Program, Don M. Chance (AIMR, 2003) [change sec. 2.2.1
and 2.2.2 from optional to required]
43. “Risk Management Applications of Swap Strategies,” Ch. 8, Analysis of Derivatives for
the CFA® Program, Don M. Chance (AIMR, 2003).
Purpose:
To test knowledge and use of equity option strategies. To test knowledge and use of futures to
alter risk exposure in an equity portfolio.
LOS: 2010-III-15-41-a-c,e-42a,b,e,f
41. “Risk Management Applications of Forward and Futures Strategies”
a) demonstrate the use of equity futures contracts to achieve a target beta for a
stock portfolio and calculate and interpret the number of futures contracts
required;
b) construct a synthetic stock index fund using cash and stock index futures (equitizing
cash);
c) create synthetic cash by selling stock index futures against a long stock
position;
d) demonstrate the use of equity and bond futures to adjust the allocation of a portfolio
between equity and debt;
e) demonstrate the use of futures to adjust the allocation of a portfolio across equity
sectors and to gain exposure to an asset class in advance of actually committing
funds to the asset class;
f) discuss the three types of exposure to exchange rate risk and demonstrate the use of
forward contracts to reduce the risk associated with a future transaction (receipt or
payment) in a foreign currency;
g) explain the limitations to hedging the exchange rate risk of a foreign market
portfolio and discuss two feasible strategies for managing such risk.
42. “Risk Management Applications of Option Strategies”

a) Compare and contrast the use of covered calls and protective puts to manage risk
exposure to individual securities;
b) determine and interpret the value at expiration, profit, maximum profit,
maximum loss, breakeven underlying price at expiration, and general shape of

LEVEL III
Question: 7
Topic: Risk
Minutes: 20
the graph for the major option strategies (bull spread, bear spread, butterfly
spread, collar, straddle, box spread);
c) determine the effective annual rate for a given interest rate outcome when a
borrower (lender) manages the risk of an anticipated loan using an interest rate call
(put) option;
d) determine the payoffs for a series of interest rate outcomes when a floating rate loan
is combined with (1) an interest rate cap, (2) an interest rate floor, or (3) an interest
rate collar;
e) explain why and how a dealer delta hedges an option position, why delta changes,
and how the dealer adjusts to maintain the delta hedge;
f) interpret the gamma of a delta-hedged portfolio and explain how gamma changes as
in-the-money and out-of-the-money options move toward expiration.

LEVEL III
Question: 7
Topic: Risk
Minutes: 20
Guideline Answer:
PART A
i. The share price of Severn Hospitality plc becomes GBP 8.80 × 2 = GBP 17.60, in which
case the profit per share on the straddle is:
Call option’s profit of GBP 17.60 – GBP 9.00 = GBP 8.60, less the cost of both options
(GBP 0.38 + GBP 0.57) = GBP 7.65.
ii. The breakeven prices of Severn shares are GBP 9.95 and GBP 8.05. The upside
breakeven point occurs when the profit from the call option is just sufficient to cover the
costs of both options, namely (stock price – call strike price) = (price of call option +
price of put option). Solving for the stock price yields stock price of GBP 9.95. The
downside breakeven point occurs when the profit from the put option is just sufficient to
cover the cost of both options, (put strike price – stock price) = (price of call option +
price of put option). Solving for the stock price yields = GBP 8.05.
PART B
i. A bull spread would lose money if the U.K. loses the bid and the share price falls sharply,
and would make only limited profits (compared to a straddle) if the U.K. wins the bid and
the share price appreciates sharply.
ii. A short butterfly spread would make only limited gains when the share price either
increases or decreases beyond the breakeven points.
iii. A zero cost collar would lose a limited amount of money if the U.K. loses the bid, and
would make only a limited profit (compared to a straddle) if the U.K. wins the bid.

LEVEL III
Question: 7
Topic: Risk
Minutes: 20
PART C
i. Jacob wishes to eliminate all systematic risk in the Bold Beverages Pension Fund’s
equity portfolio, so the target beta must be zero. βT = 0
ii. The price of a futures contract = GBP 10 × 4,667 = GBP 46,670.
The number of futures contracts required is:
Nf = [(βT – βS)/βf] × (S/f), where S = stock portfolio, f = futures contract.
= [(0 – 1.04)/0.98] × (GBP 235,400,000/GBP 46,670)
= - 5,352.74
As fractions of futures cannot be traded, Jacob should sell 5,353 FTSE 100 futures
contracts.
PART D
The new value of the equity portfolio is GBP 235,400,000 × 1.035 = GBP 243,639,000 or a gain
of GBP 8,239,000.
The profit on the futures is (4,824 – 4,667) x GBP 10 × (-5,200) = - GBP 8,164,000 or a profit of
-3.468%.
So, the overall profit is GBP 8,239,000 – GBP 8,164,000 = GBP 75,000 and the ending value of
the overall portfolio is GBP 235,475,000.
This is an overall return of GBP 75,000/GBP 235,400,000 = 0.0003 or 0.03%
Since the market was up 3.75%, the effective beta was 0.0003/0.0375 = 0.0085.

LEVEL III
Question: 8
Topic: Portfolio Management: Monitor/Rebalance/Execution
Minutes: 17
Rav Malik, an investment advisor, meets with a new client in the U.K., Ian Brown, to discuss his
investment portfolio. Brown has managed his own assets in the past and rebalances his portfolio
to target weights at the beginning of each month.
Malik suggests that Brown consider percentage-of-portfolio rebalancing with daily monitoring
and rebalancing to target weights. He offers to demonstrate how the two approaches would
differ after rebalancing on 1 April, given the allocations shown in Exhibit 1, with tolerance bands
or corridor widths set at ± 10% of the target allocation.
Exhibit 1
Brown Asset Allocation
Strategic
Asset Closing
Asset Class Allocation: 31 March
Target Allocation
Weights
Large-cap U.K. equity 30% 27%
International equity 30% 28%
U.K. fixed income 40% 45%
A. Determine whether Brown’s calendar rebalancing method would result in a higher,

lower, or the same weighting in international equity holdings on 1 April, as compared to
Malik’s percentage-of-portfolio rebalancing method. Explain your response.
(4 minutes)
Malik tells Brown, “Before adopting percentage-of-portfolio rebalancing, we need to determine

the optimal corridor width for each asset class based on market conditions and your
circumstances.” Malik notes the following information:
• Brown’s tolerance for risk has declined as volatility in the international equity
markets has increased.
• Brown is concerned about taxes and transaction costs associated with frequent
rebalancing. Transaction costs for international equity investments are higher
than for Brown’s other asset classes.

LEVEL III
Question: 8
Minutes: 17
• Global equity market correlations are increasing and the correlation of

international equity with the rest of the portfolio is higher than the correlation of
U.K. fixed income with the rest of the portfolio.
Malik then tells Brown, “The optimal corridor width for U.K. fixed income should be narrower
than the optimal corridor width for international equity.”
B. Determine two factors that support Malik’s conclusion regarding the optimal corridor
width for U.K. fixed income relative to international equity.
(4 minutes)
Malik notes that Brown’s domestic equity allocation consists of only large-cap equity. He
discusses the possibility of adding small-cap equity to the portfolio and Brown agrees.
Malik reviews Brown’s portfolio holdings and enters two trades, shown in Exhibit 2, into the
firm’s order management system.
Exhibit 2
Trading Orders and Market Data on 1 April
(GBP = British pound)
Bid-Ask
Size Average Daily Last Price
Symbol Trade Spread
(shares) Volume (GBP)
(%)
ABCD Buy 5,000 13,000 4.15 0.79
EFGH Buy 40,000 475,000 9.14 0.06
Sean Granger, a trader at Malik’s firm, reviews the planned trades for 1 April and notes the
following:
• Malik wants to establish a long-term position in ABCD for Brown.

• Malik believes EFGH’s earnings report, scheduled to be released tomorrow
afternoon, will have a favorable effect on the share price of EFGH.
Granger considers executing the orders using a crossing system, implementation shortfall
algorithm, or volume-weighted average price (VWAP) algorithm.

LEVEL III
Question: 8
Minutes: 17
C. Recommend the most appropriate trade execution tactic (crossing system,

implementation shortfall, or VWAP) for each order.
i. Buy 5,000 shares ABCD

ii. Buy 40,000 shares EFGH
Justify each recommendation with one reason.
ANSWER QUESTION 8-C IN THE TEMPLATE PROVIDED ON PAGE 57.
(6 minutes)
That afternoon, Malik reads a research report recommending purchase of small-cap RB Holdings
Corporation (RBHC) and decides to take a position. The following sequence of events occurs:
• On 1 April, RBHC closes at GBP 10.25.

• The next morning, Malik directs Granger to enter a limit order expiring at the end
of the day to purchase 20,000 shares at GBP 10.25.
• Granger purchases a total of 6,000 shares at GBP 10.24 with commissions of GBP
400.
• On 2 April, RBHC closes at GBP 10.32, and VWAP is GBP 10.27.
• No additional shares were purchased and the remaining order is cancelled.
Granger informs Malik that his trading was successful because he paid less than the day’s
(2 April) VWAP of GBP 10.27. Malik notes that VWAP does not consider the costs of missed
trade opportunities.
D. Calculate the missed trade opportunity cost, in basis points, for the RBHC trade. Show
your calculations.
(3 minutes)

LEVEL III
Question: 8
Minutes: 17
Part C
Template for Question 8-C

Recommend the most
appropriate trade
execution tactic
(crossing system,
Order Justify each recommendation with one reason.
implementation
shortfall, or VWAP)
for each order.
(circle one)
Crossing system
i. Buy
5,000 shares Implementation shortfall
ABCD
VWAP
Crossing system
ii. Buy
40,000 shares Implementation shortfall
EFGH
VWAP

LEVEL III
Question: 8
Minutes: 17
Reading References:
Reading 44: Execution of Portfolio Decisions
Managing Investment Portfolios: A Dynamic Process, Third
Edition, John L. Maginn, CFA, Donald L. Tuttle, CFA,
Jerald E. Pinto, CFA, and Dennis W. McLeavey, CFA, editors (CFA Institute, 2007)
Reading 45: Monitoring and Rebalancing

Managing Investment Portfolios: A Dynamic Process, Third
Edition, John L. Maginn, CFA, Donald L. Tuttle, CFA,
Jerald E. Pinto, CFA, and Dennis W. McLeavey, CFA, editors (CFA Institute, 2007)
Purpose:
To test candidates’ knowledge and understanding of monitoring and rebalancing portfolios as
well as the execution of portfolio decisions.
LOS: 2010-III-16-44-g, h, j, k, l and LOS-2010-III-16-45-d, e, f OUTCOMES

a. compare and contrast market orders with limit orders, including the price and execution
uncertainty of each;
b. calculate and interpret the effective spread of a market order and contrast it to the quoted bid–
ask spread as a measure of trading cost;
c. compare and contrast alternative market structures and their relative advantages;
d. compare and contrast the roles of brokers and dealers;
e. explain the criteria of market quality and evaluate the quality of a market when given a
description of its characteristics;
f. review the components of execution costs, including explicit and implicit costs, and evaluate a
trade in terms of these costs;
g. calculate, interpret, and explain the importance of implementation shortfall as a measure
of transaction costs;
h. contrast volume weighted average price (VWAP) and implementation shortfall as
measures of transaction costs;
i. explain the use of econometric methods in pretrade analysis to estimate implicit transaction
costs;
j. discuss the major types of traders, based on their motivation to trade, time versus price
preferences, and preferred order types;
k. describe the suitable uses of major trading tactics, evaluate their relative costs,
advantages, and weaknesses, and recommend a trading tactic when given a description
of the investor’s motivation to trade, the size of the trade, and key market
characteristics;
l. explain the motivation for algorithmic trading and discuss the basic classes of algorithmic
trading strategies;
LEVEL III
Question: 8
Minutes: 17
m. discuss and justify the factors that typically determine the selection of a specific
algorithmic trading strategy, including order size, average daily trading volume, bid–ask
spread, and the urgency of the order;
n. explain the meaning and criteria of best execution;
o. evaluate a firm’s investment and trading procedures, including processes, disclosures, and
record keeping, with respect to best execution;
p. discuss the role of ethics in trading.
Reading 45: Monitoring and Rebalancing

a. explain and justify a fiduciary’s responsibilities in monitoring an investment portfolio;
b. describe and justify the monitoring of investor circumstances, market/economic conditions,
and portfolio holdings and explain the effects that changes in each of these areas can have on
the investor’s portfolio;
c. recommend and justify revisions to an investor’s investment policy statement and strategic
asset allocation, given a change in investor circumstances;
d. discuss the benefits and costs of rebalancing a portfolio to the investor’s strategic asset
allocation;
e. contrast calendar rebalancing to percentage-of-portfolio rebalancing;
f. discuss the key determinants of the optimal corridor width of an asset class in a
percentage-of-portfolio rebalancing program, including transaction costs, risk tolerance,
correlation, asset class volatility, and the volatility of the remainder of the portfolio, and
evaluate the effects of a change in any of these factors;
g. compare and contrast the benefits of rebalancing an asset class to its target portfolio weight
versus rebalancing the asset class to stay within its allowed range;
h. explain the performance consequences in up, down, and nontrending markets of 1) rebalancing
to a constant mix of equities and bills, 2) buying and holding equities, and 3) constant
proportion portfolio insurance (CPPI);
i. distinguish among linear, concave, and convex rebalancing strategies;
j. judge the appropriateness of constant mix, buy-and-hold, and CPPI rebalancing strategies
when given an investor’s risk tolerance and asset return expectations.
i. compare and contrast venture capital funds to buyout funds;
j. discuss the use of convertible preferred stock in direct venture capital investment;

Question: 8
Minutes: 17
Guideline Answer:
PART A
The two approaches, Brown’s calendar rebalancing and Malik’s percentage-of-portfolio

rebalancing, would result in rebalancing to equal weightings in international equities (30%) on
1 April. The monthly calendar rebalancing approach requires that the portfolio is rebalanced to
the strategic allocation target weights at the beginning of each month, so on 1 April, Brown’s
holdings in international equities would be increased from 28% to 30%.
Although the 28% weighting in international equities is within the tolerance band under the
percentage of portfolio rebalancing approach, the 45% weighting in U.K. fixed income is outside
the tolerance band. Thus, all asset classes would be rebalanced to target weights.
PART B
Brown’s optimal corridor width for U.K. fixed income should be narrower than the optimal
corridor width for international equities because of the following factors:
1) Higher transaction costs for international investments: High transaction costs set a high
hurdle for rebalancing benefits to overcome. Since transaction costs for international equity are
higher than transaction costs for U.K. fixed income, the optimal corridor width for U.K. fixed
income will be narrower than the optimal corridor width for international equities.
2) Higher correlation with the rest of the portfolio: International equities have a higher
correlation with the rest of the portfolio than U.K. fixed income with the rest of the portfolio.
When asset classes move together, further divergence from targets is less likely, allowing a wider
optimal corridor width for international equities compared with U.K. fixed income.
With regard to the other information noted by Malik:

Brown’s lower risk tolerance supports narrower optimal corridor widths for all asset classes, not
U.K. fixed income relative to international equities.
Increased volatility in the international equity markets would support a narrower, not wider,
optimal corridor width for international equities.

Question: 8
Minutes: 17
PART C
Template for Question 8-C

Recommend the most
appropriate trade
execution tactic
(crossing system,
Order Justify each recommendation with one reason.
implementation
shortfall, or VWAP)
for each order.
(circle one)
The ABCD order is large relative to average daily
volume and has a large spread. It is not suitable for
Crossing system
algorithmic trading and, given its low urgency, it
would be most appropriate to use a broker or
i. Buy crossing system to mitigate the large spreads. This
5,000 shares will also prevent information leakage and protect
Implementation shortfall
ABCD the client’s anonymity.
VWAP
The EFGH order is small relative to average daily
volume, but given the high urgency, it would be
Crossing system
most appropriate to use an implementation shortfall
algorithm with a high urgency setting to
ii. Buy aggressively execute the purchase. Such a trading
40,000 shares strategy breaks up the order and seeks to minimize
Implementation shortfall
EFGH the weighted average of market impact costs and
missed trade opportunity costs.
VWAP
PART D
Missed trade opportunity cost reflects the difference between the trade cancellation price and the
original benchmark price based on the amount of the order that was not filled,
or: % unfilled × (difference between new closing price and benchmark price/ benchmark price) =
14,000/20,000 × ((10.32 – 10.25)/10.25 ) = .70 × .0068294 = .0047805% or 48 basis points

LEVEL III
Question: 9
Topic: Performance Evaluation
Minutes: 12
P&M Capital has been selected to manage a U.S. equity portfolio for a Japanese institutional
investor, Tamui Life Company. P&M intends to use an active strategy to manage Tamui’s
portfolio of approximately 300 equities. Tomoko Sato, an analyst in Tamui’s international
investment division, is determining a benchmark to evaluate the portfolio’s performance. Sato
seeks the highest quality benchmark so that investment risk may be effectively managed. Sato
concludes that a custom benchmark would be too costly for Tamui. Both parties agree that a
broad market index would be most appropriate for this mandate. Sato is asked to evaluate the
quality of three possible benchmarks:
• S&P 500
• Russell 1000
• Russell 3000
Sato produces Exhibit 1 to compare Tamui’s portfolio to the three possible benchmarks.
Exhibit 1
Comparison of Tamui’s Portfolio to Possible Benchmarks
Tamui S&P Russell Russell
Statistic
Portfolio 500 1000 3000
Average price-to-book ratio 1.95 2.06 2.13 2.09
Beta relative to the benchmark --- 1.03 0.85 0.92
Median market capitalization (U.S. dollar billions) 5.60 7.98 3.28 0.59
Volatility (annual) 12.0% 18.7% 10.3% 10.4%
Tracking error relative to the benchmark --- 1.87% 4.72% 2.07%
Dividend yield 1.86% 2.45% 2.08% 1.76%
A. Recommend, from among the three possible benchmarks presented in Exhibit 1, the
highest quality benchmark for Tamui’s portfolio. Justify your recommendation with two
reasons, using information provided in Exhibit 1.
(5 minutes)
Sato is directed by management to prepare a micro-attribution report for Tamui’s portfolio using
a fundamental factor model. She uses portfolio analysis software to produce Exhibit 2.

LEVEL III
Question: 9
Minutes: 12
Exhibit 2
Fundamental Factor Model Micro-attribution Report for Tamui’s Portfolio
for the Quarter Ended 31 March
Portfolio Normal Active Active
Returns and Attribution Return
Exposure Exposure Exposure Impact
Market return –8.42%
Normal portfolio return –7.81%
Cash timing 3.20 0.00 3.20 0.16%
Beta timing 1.17 1.00 0.17 –0.17%
Total market timing –0.01%
Growth 1.23 0.87 0.36 –0.30%
Size –0.20 0.34 –0.54 0.20%
Leverage –0.36 –0.72 0.36 0.09%
Yield –0.10 0.00 –0.10 0.35%
Total fundamental risk factors 0.34%
Total economic sectors –0.15%
Specific (unexplained) –0.58%
Actual portfolio return –8.21%
B. i. Determine which overweight exposure added the most active value to Tamui’s
portfolio.
ii. Determine which underweight exposure added the most active value to Tamui’s
portfolio.
(4 minutes)
C. Calculate the value added to Tamui’s portfolio through active management for the
quarter ended 31 March.
(3 minutes)

LEVEL III
Question: 9
Minutes: 12
Reading References:
2010 Level III, Volume 6, Study Session 17
46. “Evaluating Portfolio Performance,” Ch. 12, Managing Investment Portfolios: A
Dynamic Process, 3rd edition, Jeffrey V. Bailey, Thomas M. Richards, and David E. Tierney
(CFA Institute, 2007).
Purpose:
To test the candidate’s knowledge of performance evaluation and attribution
LOS: 2010-III-17-46-e,f,i,m
46. “Evaluating Portfolio Performance”

a) demonstrate the importance of performance evaluation from the perspective of fund
sponsors and the perspective of investment managers;
b) explain the basic components of portfolio evaluation (performance measurement,
performance attribution, and performance appraisal);
c) calculate, interpret, and contrast time-weighted and money-weighted rates of return
and discuss how each is affected by cash contributions and withdrawals;
d) identify and explain potential data quality issues as they relate to calculating rates of
return;
e) demonstrate the analysis of portfolio returns into components attributable to
the market, to style, and to active management;
f) discuss the properties of a valid benchmark and evaluate the advantages and
disadvantages of alternative types of performance benchmarks;
g) summarize the steps involved in constructing a custom security-based benchmark;
h) judge the validity of using manager universes as benchmarks;
i) evaluate benchmark quality by applying tests of quality to a variety of possible
benchmarks;
j) discuss the issues that arise when assigning benchmarks to hedge funds;
k) distinguish between macro and micro performance attribution and discuss the inputs
typically required for each;
l) demonstrate, justify, and contrast the use of macro and micro performance
attribution methodologies to evaluate the drivers of investment performance;
m) discuss the use of fundamental factor models in micro performance
attribution;
n) differentiate between the effect of the external interest rate environment and the
effect of active management on fixed-income portfolio returns;
o) explain the management factors that contribute to a fixed-income portfolio’s total
return and interpret the results of a fixed-income performance attribution analysis;

LEVEL III
Question: 9
Minutes: 12
p) calculate, interpret, and contrast alternative risk-adjusted performance measures,

including (in their ex post forms) alpha, information ratio, Treynor measure, Sharpe
ratio, and M2;
q) explain how a portfolio’s alpha and beta are incorporated into the information ratio,
Treynor measure, and Sharpe ratio;
r) demonstrate the use of performance quality control charts in performance appraisal;
s) discuss the issues involved in manager continuation policy decisions, including the
costs of hiring and firing investment managers;
t) contrast Type I and Type II errors in manager continuation decisions.

LEVEL III
Question: 9
Minutes: 12
Guideline Answer
PART A
S&P 500 is the highest quality benchmark for Tamui’s portfolio. This recommendation is based
on the following factors:
• The beta of Tamui’s portfolio relative to the S&P 500 Index is 1.03. Over time, there
should be minimal systematic biases or risks in the benchmark relative to the portfolio.
One measure of this criterion is the historical beta of the portfolio relative to the
benchmark; on average, it should be close to 1.0.
• The tracking error of Tamui’s portfolio relative to the S&P 500 Index is the lowest
(1.87%) of the three alternative benchmarks, indicating that the S&P 500 Index is largely
capturing the portfolio’s investment style. Tracking error measures the standard
deviation of (Pt – Bt), where Pt is the portfolio return in time period t and Bt is the
benchmark return in time period t. This is a different concept than the standard deviation
or volatility of the individual indices, which are not factors in determining the highest
quality benchmark. A high quality benchmark should reduce the “noise” in the
performance evaluation process. Therefore, the tracking error of the portfolio relative to
a high quality benchmark should be lower than the tracking error relative to alternative
benchmarks.
• Market capitalization is used as a method of evaluating the appropriateness of a

benchmark given a manager’s investment style, rather than as a test of benchmark
quality.
PART B
i.
The overweight exposure to Cash Timing contributed the most active value, +0.16%. The micro
attribution analysis in Exhibit 2 attributes the value added by the manager to four primary
sources: market timing, fundamental risk factors, economic sectors, and a stock-specific or
unexplained return component. The Active Exposure column in Exhibit 2 indicates that there are
four overweight exposures, two of which contributed active value, Leverage and Cash Timing.
Leverage contributed 0.09% of active value, while Cash Timing contributed 0.16%. The other
two overweight exposures, Beta Timing and Growth, contributed negative value to the portfolio.

LEVEL III
Question: 9
Minutes: 12
ii.
The underweight exposure to Yield contributed most to active value, + 0.35%. The micro
attribution analysis in Exhibit 2 attributes the value added by the manager to four primary
sources: market timing, fundamental risk factors, economic sectors, and a stock-specific or
unexplained return component. The Active Exposure column indicates that there are two
underweight exposures, both fundamental risk factors: Size and Yield. Size contributed 0.20%
of active value, while Yield contributed 0.35%.
PART C
The value added to Tamui’s portfolio through active management was -0.40%. The portfolio
return was -8.21% compared to the normal portfolio of -7.81%. P&M reduced value through
active management because the total return attributable to active decisions made by the manager
(market timing, fundamental risk factors, economic sectors, and stock specific risk or
unexplained) sums to -0.40%.


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LEVEL III

QUESTION 1 HAS FIVE PARTS (A, B, C, D, E) FOR A TOTAL OF 35 MINUTES.

DuBord notes the following factors:

2010 Level III Guideline Answers

2010 Level III Guideline Answers

A. Formulate each of the following constraints of Lima’s investment policy statement

B. i. State the return objective portion of Lima’s IPS.

C. i. Identify two factors that increase Lima’s ability to take risk.

Note: Assume no transaction costs or liquidity needs.

ANSWER QUESTION 1-E IN THE TEMPLATE PROVIDED ON PAGE 5.

2010 Level III Guideline Answers

Template for Question 1-E

2010 Level III Guideline Answers

LOS 2010 –III-3-14-a,h, i, j, k, l “Managing Individual Investor Portfolios”

2010 Level III Guideline Answers

2010 Level III Guideline Answers

i. Liquidity Needs for Elisa Lima:

ii. Time Horizon Constraint for Elisa Lima:

i. Return Objective Statement

2010 Level III Guideline Answers

ii. Return Calculation

Assets Needed to Purchase Annuity at age 60 (pretax)

Required Return Calculation

CPT I/Y – TVM registry of calculator 7.05% pretax nominal

i. Factors that increase Lima’s ability to take risk:

ii. Factors that increase Rual’s ability to take risk:

Rual has a greater willingness to take risk because:

2010 Level III Guideline Answers

Abella Rual’s New Asset Location

2010 Level III Guideline Answers

Template for Question 1-E

Bonds 0 USD 500,000

Equities USD 500,000 0

Bonds USD 500,000 0

Equities 0 USD 500,000

2010 Level III Guideline Answers

QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 25 MINUTES.

• insurance companies that consolidate investment portfolios to pay a 10% tax on

2010 Level III Guideline Answers

A. Determine the effect (increase, no change, decrease) on each of the following

Justify each response with one reason.

ANSWER QUESTION 2-A IN THE TEMPLATE PROVIDED ON PAGE 15.

“The primary objective of Island Life’s fixed income portfolio is to avoid

2010 Level III Guideline Answers

C. Explain how Stewart exhibits each of the following behavioral biases:

D. Describe two examples of Stewart’s behavioral bias of overconfidence.

2010 Level III Guideline Answers

Template for Question 2-A

2010 Level III Guideline Answers

Determine the effect

Gambler’s Fallacy Stewart’s uses a small sample of observations of below-average

Regret Stewart exhibits the bias of Regret or Regret Avoidance in two

• The narrow range of potential outcomes in his forecast.

2010 Level III Guideline Answers

QUESTION 3 HAS TWO PARTS (A, B) FOR A TOTAL OF 24 MINUTES.

ANSWER QUESTION 3-A IN THE TEMPLATE PROVIDED ON PAGE 22.

CarbX Corp is an unprofitable U.S.-based producer of automobile engine components. Its

2010 Level III Guideline Answers

B 10% nominal bonds 10% equity

C 10% real rate bonds 10% nominal bonds

D 10% real rate bonds 10% equity

E 10% equity 10% nominal bonds

F 10% equity 10% real rate bonds